|Summary: Last week’s move by the European Central Bank to cut interest rates has simultaneously strengthened the Australian dollar and weakened the ability of the Reserve Bank to raise interest rates, at least in the medium term. The rally in the long-term bonds across Europe spells massive danger for European banks and now means that quantitative easing there is essential.|
|Key take-out: For Australian investors, this will mean our interest rates will stay low and long-term yields will move down, exacerbating the chase for higher yields on the ASX.|
|Key beneficiaries: General investors. Category: Economics and investment strategy.|
To coin a phrase from Malcolm Turnbull, “With friends like Europe, Australia does not need enemies”.
That may sound harsh, but investors need to understand that the updated policy settings of the European Central Bank (ECB) that were announced last week have set world financial markets on a manic course. From an Australian perspective it has placed another roadblock in the way of the $A undertaking a much-needed devaluation and it has corrupted the ability of the Reserve Bank of Australia to adjust our interest rates. The recent and sharp decline in the iron ore export price (our largest export) should result in a declining $A. But, alas, the ECB has potentially halted this – at least for a short period.
There should be no doubt that the cutting of European cash rates to below “zero” will add to the pressure creating inflated asset prices. It is a desperate act and it may well be the icing on the cake for speculators. However, I believe that the stated intention by the ECB to introduce European quantitative easing is a tacit admission that it perceives that there are problems developing for the European banking system, and I do too.
I will explain my thesis with the help of a few charts, but at the outset I do make the disclaimer that I do not know what the future holds. However, I feel comfortable to suggest that the ECB does not either. Indeed, I suspect it is concocting policies in an attempt to stave off a period that is similar to that which has afflicted Japan for over 20 years. It clearly has no idea what will result from its policies as it desperately tries to maintain confidence in the financial system.
The above chart shows that both the US Federal Reserve and the ECB have cut real interest rates to below zero. The ECB has become more aggressive as European inflation readings have fallen to 1%. European inflation is now below that of Japan. This has not occurred for over 20 years.
The slowest growing central bank has been the ECB. Total developed economy central bank assets (including the Bank of England) has lifted above $US10.5 trillion. On average, central banks own assets that represent between 20% and 25% of their economy’s GDP. The bulk of these are government bonds, but in the case of the ECB the assets are mainly loans granted to European commercial banks – and that is the problem.
What has occurred in Europe, unlike other developed economies, is that the ECB has been hamstrung by the constitution of Germany, which has forbidden quantitative easing. This has meant that the ECB has been unable to undertake quantitative easing, since Germany virtually controls ECB decision making. Therefore the ECB has done the next best thing and lent massive amounts to European banks for nominal rates of interest with essentially no maturity or repayment terms. Where this money comes from is a bit of quandary, but the ECB promises that it has not printed any.
The stated aim was to create credit that would flow through European economies to generate growth. However, the recession in Southern and Western Europe was so severe that no level of interest rates could stimulate credit growth. Indeed private-sector credit growth is negative.
So where has all this liquidity ended up? Well, essentially the banks have been buying European bonds. They have borrowed cheaply from the ECB and bought European government bonds. They have lent to near bankrupt European governments that include Greece, Portugal and Ireland. This has meant that European countries, despite enormous levels of debt, have been able to raise more debt and pay levels of interest that defy the risk of default or inflation.
The problem that is developing is not apparent to many, but the chart above gives you a hint of the trouble that lies ahead. Noteworthy is that after the ECB announcement last Thursday we saw European bonds rally once again. For instance, French 10-year bonds reached an all-time low yield of 1.6%.
Indeed, it is the rally in the long-term bonds across Europe that spells massive danger for European banks and now means that QE is essential, no matter what the Germans say. I believe that European commercial banks are full of long-dated European bonds and the purchasing of these has created the impression of short-term profitability and stability. The banks have borrowed for virtually no cost and bought bonds (underwritten by the ECB) to create an interest margin and book profits as bonds have relentlessly rallied as the banks purchased them in tandem. As yields compressed at the short end (less than three years) the banks merely extended their purchases out in maturity. A fortuitous period has resulted – just like it did prior to the GFC.
What this means is that the ECB will soon have to enter bond markets, through a massive QE program, to hold down European bond yields. The banking system will simply not be able to withstand a correction in bond prices that would be magnified at the longer end of the yield curve. Bond losses caused by bond yields moving to more normal levels would result from any lift in economic growth. This would result in bond losses and a depletion of bank capital. The most exposed banks may well be the large German banks themselves.
Conclusions for investors
On Monday night the German stock index reached an all-time high as it breached 10,000 points. It has risen by more than 30% in the last year and by over 100% in the last three years. Is it a bubble or is it reflecting a strong economic growth outlook?
In my view it is a developing bubble that will continue due to the policies of the ECB. The continued depression of bond yields does create the appearance of value in equity markets, as reflected in relative equity earnings yields. However, the proxy (i.e. the long-dated bond yield) is manipulated by the ECB such that risk is no longer in the price.
To explain this, think of where Europe can go from here.
If it grows and creates inflation of 2% to 2.5% per annum then what do you think the yields on German and French bonds will do? They should lift and bond prices should fall, unless the ECB buys bonds at the same ridiculous rate that is occurring in Japan.
The alternative is a rolling recession that results in government debt that simply overwhelms the bond market and causes a collapse in the confidence of bond holders in the financial system. Once again the ECB will have to stand in markets with QE.
Frankly the ECB should have moved to QE a few years ago and its failure to do so will now result in a speculative bubble, the likes of which no-one can comprehend.
For Australian investors this will mean that our interest rates will stay low and I fully expect that there will be an overflow of international buying interest in our bond market from Europe and Japan. Long-term yields will move down, and the RBA will not be game to put up interest rates given the mess in Europe and the effect on our dollar. The manic chase for yield will continue and Australian savers will suffer a long period of negative real interest rates on deposits.
In closing, I wonder what our Treasurer and the RBA will say and do if our 10-year bonds rally to below 3% in the coming six months? They certainly should admit that it has nothing to do with them, and they should acknowledge that such rates are unsustainable. If they are thinking and planning, they would be ready to grab all the long-term debt funding they can get.
John Abernethy is the Chief Investment Officer at Clime Asset Management. Clime offer excellent performing growth and income portfolios through its individually managed accounts service. To find out more, or to request a review of your share portfolio, call Clime on 1300 788 568 or visit www.clime.com.au.